How to Effectively Negotiate Loan Covenants

Banks may be receptive to terms that further a well-conceived business plan.

If
you are responsible for raising capital, you are probably aware that
many banks have become very strict in the arrangement of loan
covenants since the collapse of the housing market. Breaching, or
“tripping,” a covenant can have a devastating effect on any
business. This article explains how to negotiate fair covenants with
a banker and offers suggestions on what to do if a breach is imminent.

COVENANT NEGOTIATION

It is
possible to effectively negotiate with your banker, and you should
understand how to appeal to the banker’s best interests. Preparation
is a key element in covenant negotiation. Some finance professionals
first see covenants when asked to sign the loan documents, but they
have had no preliminary discussions and believe that covenants are a
one-sided dictation from the bank. In general, this is not true.
Although certain covenants must be expected in a commercial loan, a
knowledgeable CPA should effectively negotiate fair and reasonable covenants.

Before
starting any negotiation with your banker, construct a conceptual
framework of any covenant types that might be especially negative to
your particular business. You must have a clear idea where your
strengths lie and negotiate your covenants in that direction. For
example, if your business has significantly deleveraged recently but
your financial projections indicate potential losses for the next
fiscal year, you would want to mitigate the effect of
income-statement-based covenants by expressing your concerns and
suggesting a realistic cushion in the required minimum or maximum
limits. If your business plan requires expansion based on a
mergers-and-acquisitions strategy, you would clearly need to include
this as a key point in negotiations that might include restrictive covenants.

The
bank will expect to include covenants that protect its interests.
However, bear in mind that banks want your business to succeed. They
prefer to help businesses grow so that their risks remain low and
more loans are requested from the bank. If the CPA can present a
well-conceived business plan and suggest covenants with appropriate
limits that contribute to the success of the plan, most bankers will
seriously consider the proposal. You can discuss any part of a
proposed covenant in the give-and-take of a negotiation, but you
must be prepared to offer well-considered and reasonable
counterproposals to achieve a positive result.

Covenants
should be reviewed collectively to achieve a logical result. Often,
restrictive covenants are interspersed with boiler plate legalese in
loan documents. These should be pulled out and listed together for
review. Covenant language in multiple loans with the same bank
should also be examined collectively to eliminate conflicts and
unintended consequences. Take the following steps before entering
into negotiations with a banker over covenants:

Put
yourself in the banker’s position based on your understanding of his
or her internal and regulatory demands. Make a list of covenants
that you would require if you were the banker.

Develop
a specific set of realistic covenants from your perspective. Ask
yourself what kind of covenant structure is reasonable based on your
company’s financial position, then compare it to your business plan
to ensure that your proposal does not restrict the company’s ability
to execute effectively.

Begin a
hypothetical discussion with your banker about the covenants that
should be included in your next renewal. Stress that your
conversation is hypothetical so that the conversation does not move
too quickly into the realm of fact and negotiation. Use “what if”
questions and gauge your banker’s response. Ask a broad range of
questions. From this, you can get a feel for what position the bank
will take under certain scenarios.

It
can be very difficult to adjust covenants once agreed to, so the key
to effective covenant negotiation lies in preparation before the
loan agreement is signed.

Measure
proposed covenants against your most recent financials and your best
projections. Look as far into the future as you can reliably project
to determine if the covenant you agree to today will cause a problem
in a couple of years based on future losses, equity issues and so on.

Covenants
should also be compared to the near-term and long-term business plan
for possible conflicts to determine if your plans for growth could
be subject to restrictive covenants.

You
should carefully gauge your relationship with your bank, and do
everything possible to foster an open and communicative two-way
association. Some banks have more Draconian credit policies than
others. It never hurts to know, and talk frequently with, more than
one banker. By developing these diversified relationships, you can
better judge the fairness of proposed covenants.

If
your business is in a strong enough financial position to be
attractive to other financial institutions, you should consider
additional sources of capital. Credit policy can change quickly at
any bank due to acquisitions, regulatory issues or internal needs.
Even if you don’t think your business is large enough to justify
multiple banking relationships, get to know loan officers at other
banks. Tell them about what you’re doing and see if they’ll make
competitive offers.

MONITOR
YOUR COVENANTS

One
of the most critical aspects of effectively managing any loan
relationship relates to constant monitoring of current covenant
results through interim financial statements. In addition, all
financial projections and prospective budgets should include a
section on how loan covenants will be impacted.

Create a
proactive system to monitor progress on all financial loan
covenants. Recently, the Department of the Treasury and the Federal
Reserve required many banks to pass a stress test to determine how
the banks would perform under various circumstances. Create a
stress-test system for your company by varying your latest financial
results. For example, reduce revenues by 15%, increase your variable
costs by 10%, then calculate how these changes affect your financial
covenants. The result will constitute your covenant risk profile.
You will gain a clear understanding of how certain events will
affect the risk of a covenant breach.

Each
interim financial statement and future projection should feature a
covenant calculation measured against the results required by the
loan documents. Track this data over time and adjust your covenant
risk profile based on changes in your projections.

HOW
TO DISCUSS COVENANT BREACHES

Possibly
the most important aspect of the CPA’s involvement in covenant
review is when and how to communicate with a banker on covenant
performance. The life or death of a company can depend on how this
step is handled.

What
specific steps should you take in communicating with the banker on
potential covenant breaches? Given enough time, many potential
covenant breaches can be absorbed by the bank, allowing as much
consideration as possible for a reasonable reaction. Waiting until
the last minute to disclose a breach is almost universally a bad idea.

When
projections indicate that a financial covenant breach is possible,
it is best to discuss the situation with your banker. Bankers hate
surprises. Tell the banker that your early projections indicate a
potential covenant problem and you want to discuss the possible
effects. Although this discussion is not hypothetical, it is based
on projections. This way, the banker is
forewarned that a breach could occur, but he or she is not
necessarily alarmed. The conversation can have a more relaxed tone
than one occurring at the last minute based on a certain breach. The
bank will monitor covenant progress more closely, and hopefully you
can prevent the breach from occurring.

If a
breach does not occur, the banker will have gained greater insight
into your business and more faith that you will not be the source of
last-minute surprises. If a breach does occur, the bank will have
had ample time to react appropriately.

WHAT TO
EXPECT FROM A BREACH

Covenant
breach penalties are almost completely within the control of the
bank and can range from a simple caution letter added to your file
(after you request a breach waiver) to the calling of all loans and
the termination of a relationship. A covenant breach, no matter the
severity, is a technical violation of the loan agreement and allows
the financial institution to take any action legally available.

Midrange
penalties could include a change in the interest rate paid or a
onetime monetary penalty. This step can be controlled to some extent
by taking timely steps appropriate to the circumstances.

Once
a covenant breach is certain and the severity of the breach is
clear, send a letter to your banker outlining the circumstances and
requesting a waiver or reduction of penalty. You should have a
reasonably clear idea of how the bank will react given your prior
meetings on the subject.

Be
prepared to negotiate if the penalty is unreasonably severe. A
comparison of how other banks are reacting more favorably to the
same circumstances could be useful. Diplomacy is a key skill at this
point. Once a covenant is breached, a great deal of the power shifts
to the discretion of the bank. Consider discussing how the severe
penalty could impair the business and increase the ultimate risk to
the bank.

CONCLUSION

It is
critical to stay ahead of the curve on all covenant issues in
today’s tight credit environment. Failure to do so can place your
organization at a competitive disadvantage. Talk to your bankers so
you understand the forces driving their credit decisions.

View
your banking relationships holistically and with an intention to
engage in healthy, profitable relationships. Negotiation is always
possible if you take the time to gain useful knowledge, create
strong relationships, and engage in well-timed discussions on
covenant issues. Every negotiation is different, and it is not
possible to provide advice to fit all circumstances. Enter any bank
negotiation cautiously and fully prepared with a well-considered
plan of action.

Why Banks Require Covenants

To effectively negotiate with a banker, you must
understand how a financial institution judges and mitigates risk.
In general, your ability to negotiate will be a reflection of the
overarching relationship with your bank. It is very important to
foster a long-term positive and honest relationship with your
banker.

Understand that your banker must deal with internal
policies and external regulators in defending any part of your
loan package. Depending on the size of the loan, your banker may
be required to stand before a formal loan committee composed of
credit officers responsible for ensuring that the bank does not
accept undue risk. The credit committee will ask many in-depth
questions, so providing your banker with as much supporting
information as possible (your business plan, financial
projections, etc.) is very beneficial. Your banker will be asked
to justify to a skeptical committee why he or she wishes to
structure the covenants and interest rate in a particular fashion.

The committee will usually review the overall
profitability of the relationship, generally using a profitability
model such as Risk Adjusted Return on Capital (RAROC). Once the
loan is approved, an external regulator could review the entire
package to determine if it agrees with the structure.

Common Covenants

In general, loan documents will contain both
financial and restrictive covenants. Knowledge of how these
covenants are constructed and why they might be included is very
important in negotiating an effective loan agreement. When
properly considered and effectively applied, covenants can
provide sound benchmark metrics that are healthy for the
organization. Poorly conceived covenants can devastate a
business and wreck its capital base. It is the CPA’s job to know
the difference, negotiate effectively and protect businesses
from capital disruption.

Financial Covenants

Financial covenants are usually derived from common
ratios and other metrics based on the balance sheet
(debt/equity), the income statement (operating profit, EBITDA),
and the statement of cash flows (operating cash flow). EBITDA
can be used as an approximation of positive cash flow.

Some covenants, such as debt service coverage
ratios, reference several financial statements. See the most
common financial covenants in Exhibit 1 and run those
calculations through your most recent financial statements to
determine which are the most beneficial and detrimental to your
interests.

Many businesses have unique characteristics, and it
is important to review your financial statements to determine if
any presentation issue might alter the expected covenant
calculation. For example, a business that holds high-cost,
long-lived rental inventory might present that inventory as a
depreciable asset rather than a current asset. The debt acquired
in the purchase of the depreciable rental inventory will be
presented as both long-term debt and the current portion of
long-term debt. In this case, a current ratio may be less
favorable since the assets supporting the current debt are not
necessarily categorized as a current asset. At the least, some
modification to the current ratio calculation should be
negotiated into the covenant.

Exhibit 1: Basic Financial Covenants

Net worth

Interest coverage ratio

Liquidity and performance ratios

Fixed charge coverage ratio

Current ratio/working capital

Debt ratio (leverage ratio)

Debt service coverage
ratio

Restrictive Covenants

A restrictive covenant requires a company to act or
not act in a certain way unless permission is expressly granted
by the bank. For example, a bank may require a company to carry
key-man insurance on principle executives, maintain property
insurance or obtain permission before entering into a merger or
acquisition.

Restrictive covenants tend to blend into the text
of long loan documents, and you should be careful to identify
any circumstances or actions for which the bank expects to grant
permission. Poorly considered restrictive covenants can limit an
organization’s growth. A full discussion of the company’s
business plan with the bank and how restrictive covenants might
negatively affect long term profitability should be
considered.

EXECUTIVE SUMMARY

Prepare to negotiate covenants by constructing a conceptual
framework of any covenant types that might prove to be
especially negative to your particular business. Have
a clear idea where yourstrengths lie and negotiate
your covenants in that direction.

Create a proactive system to monitor progress on all
financial loan covenants.

Discuss potential covenant breaches with your banker as soon
as possible. Waiting
until the last minute to discuss a covenant breach is almost
universally a bad idea.

Once a covenant breach is certain and its severity is clear,
send a letter to your banker outlining the circumstances and
requesting a waiver of penalty. Be
prepared to negotiate if the penalty is unreasonably
severe.

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